Global Halal Investing Journal

What is a Robo-Advisor and Why Should You Care

Robo-Advisors are emerging as favorites for millennials due to their generally low account minimums, low fees, and efficient structure.

Diversification, ETFs, Mutual Funds… We’re assuming that these terms are not your cup of tea?

Investing is undoubtedly no easy task. It may seem daunting to inexperienced investors with all that financial jargon flying around.

The fact of the matter is that saving and investing at a young age can prove to be a huge advantage, and robo-advisors (RA’s) are here to help with exactly that.

What is a robo-advisor?

RA’s are simply automated, financial advisors. The online tools act as a financial advisor would in picking an optimal investment portfolio for you.

Most of them start by asking you a few questions to understand your risk appetite and allocate your investments accordingly based on certain algorithms. Once you agree to your allocation, you fund your account and the RA will go from advice to action, buying the securities for you and managing your portfolio by rebalancing it periodically. It’s that simple for you as a client.

One thing you may not know is that there has been extensive research on measuring an individual’s risk tolerance, as studies show that one may overestimate the amount of risk they are willing to take to meet return objectives. Many RA’s have designed processes around that concept by asking few, but carefully designed questions with a specific scoring method.

The logic behind the methodology

The general concept is that typically, a more aggressive portfolio would have a larger allocation to stocks and may experience larger short-term swings compared to a conservative portfolio, which would have a larger allocation to fixed income investments.

The hypothetical example below is like an excerpt you’d see in ‘Risk Tolerance for Dummies’. It’s broken down to the very basics.

“Let’s take a look at Mr. Smith, a 60-year-old farmer who’s retiring soon, and Mrs. Green, who’s a 30-year-old lawyer. Since Mr. Smith is likely to retire soon, he’d want to protect his wealth and will be happy with a modest gain. After all, he’s going to live the rest of his life mostly off of his savings. Mrs. Green, on the other hand, is further away from retirement, and will more likely tolerate a few swings in her portfolio for the possibility of larger returns after 30 years. She has some time to cover up for losses.”

Investing

To understand how most robo-advisors invest, we’ll quickly explain passive and active investing, highlighting the main difference between the two. We’ll then clarify what exchange-traded funds are.

Passive and Active Investing

First, let’s explain the difference between active and passive management.

An active investor is someone who tries to ‘buy low and sell high’ several times to make a profit. It’s not easy. In fact, it can be more difficult than trying to guess the plot of the next Game of Thrones episode.

A passive investor, on the other hand, creates an ‘optimal’ allocation and sticks with it. The passive manager believes that timing the market may generate returns in the short term, but overall the active manager will underperform a passive one due to the sheer difficulty of timing the market.

A paper by ‘Benke and Ferri 2013’ showed that a passive manager outperforms a comparable active manager 82% of the time! (Between 1997 and 2012)

Many robo-advisors, therefore, implement a passive investing approach. The fees paid to passive managers are considerably less than the ones paid to active ones, which can be quite attractive to clients.

Exchange-Traded Funds: How Robo-Advisors Invest

The concept is straightforward. Exchange Traded Funds (ETF’s) are a group of stocks or securities. It’s like grouping GM, VW, Ford, and Fiat-Chrysler all in one fund, and then buying shares in the fund instead of buying shares in each company separately.

These funds are called exchange-traded funds, simply because, they are traded on an exchange. So you can buy shares in these funds just like you would buy common stocks.

Robo-advisors want to ensure a smooth and profitable ride for the client with a lower probability of losing money. Therefore, robo-advisors primarily invest in ETF’s.

New Diversification Options with New Robo-Advisors

In addition to stability, diversification is key when investing, not only through different stocks but across different asset classes as well. Robo-advisors’ passive investment strategies are built around that concept.

For example, an ETF tracking small tech companies that are trying to change the world will be more volatile than an ETF tracking the largest utility companies. The different weightings assigned to each ETF are the bread and butter of robo-advisor allocation models.

More importantly, fixed income investments play an extremely vital part of portfolio diversification due to their low correlation with stocks. Halal bonds, which are known as Sukuks or Islamic bonds have typically been inaccessible by retail investors as they’re sometimes traded in blocks of $200,000. Moreover, most Sukuk owners hold on to their bonds until maturity, thereby limiting the growth of a secondary market where Sukuks can be traded.

One advantage of using Wahed as your robo-advisor is access to this crucial asset class. In addition to enjoying lower fees with Wahed, the Sukuk fund Wahed is working with has agreed to waive certain expenses for our clients!

We’re always finding new ways to revolutionize financial services at the intersection of robo-advising and Halal investing.

Open up your first account with an Ethical robo-advisor in minutes with Wahed today!

This material is for informational purposes only. The information is not intended to be used as the only basis for investment decisions, nor should it be construed as advice designed to meet your particular needs. You are advised to seek the advice of your financial adviser, legal or tax professional, prior to making any decision based on any specific information contained herein.

Any links to third-party websites are provided strictly as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites nor do we endorse the content and information contained on those sites. When you access one of these websites, you are leaving our website and assume total responsibility and risk for your use of the third-party websites.

Note: No Articles published on this website shall be reproduced in any form without the prior written permission of Wahed Invest.

14 Comments

Khairul Kamal bin Subari

Need to know more on overseas investment, like me being a foreigner. How will my investment guaranteed safe.

Salaam,
When do you open in Indonesia? As you may know Indonesia is the most populous country in SEA and most Muslim-populous country in World. And the investment penetration still very low due to lack of investment literation as well as Islamic investment penetration. The most challenge here is that the regulation barrier. But as you know it lies greatest potential to be developed by your business. Hope to see you in Indonesia. 🙂

In the US we are registered by the SEC (Securities and Exchange Commission) and for our international platform, we are regulated Investment Dealer under the FSC (Financial Services Commission) in Mauritius. Please note that in order to open an account on our US platform you need to have the following requirements: Valid US social security number, US permanent address with address proof, a personal bank account in the US and a US government-issued ID.

If you do not have one of the above-mentioned documents, you can open an account on our international platform by downloading our mobile App using the links below. If you require any further assistance, kindly send us an email to [email protected]